Is The Calpine Dip An Opportunity?
Summary Calpine one of the largest power generators in the U.S. and Canada, with ~27,000 megawatts of generation capacity. It’s our belief that this best-in-class operator is being unduly punished by the decline in oil & gas prices. We find the shares to be incredibly attractive at current levels, with an FCF yield of 17.33% (low-end adj. FCF 2016) and EV/EBIT of 13.51. The low commodity prices in natural gas have generate negative sentiment around Calpine (NYSE: CPN ). The company has ~27,000 megawatts of generation capacity, with 97% being natural gas-fired. Normally, you’d think this would be a good thing for the company and its customers, but the market doesn’t see it that way. Anything natural gas-related is being sold, regardless of the underlying fundamentals. The continued drop in oil & gas prices dictates that electricity will remain low. Calpine is still able to generate excess free cash in a low electricity price environment; however, it gets better margins on high prices. With that said, we don’t expect oil & natural gas prices to remain at these depressed levels forever. So, is the dip in Calpine an opportunity to back up the truck in this best-in-class utility operator? The largest provider of electricity from natural gas and geothermal Calpine was founded in 1984, and is one of the largest power generators in the U.S. The company has ~27,000 megawatts of generation capacity from 83 power plants in 19 states and Canada. It has a formidable presence in the increasingly competitive wholesale power markets in the northeastern U.S., California, and Texas. In addition, it owns natural gas and geothermal power plants across North America. (click to enlarge) Essentially, the company’s power generation portfolio consists of natural gas combustion turbines and renewable geothermal conventional steam turbines. (1) Calpine is one of the largest owners of cogeneration plants and industrial gas turbines. (2) It also has one of the largest geothermal power portfolios in the U.S. with its Geyser assets in northern California. The company generates ~15% of renewable energy in California. (click to enlarge) Calpine has strong competitive advantages from its scale, low-cost status, and geographic presence. The natural gas shale revolution has certainly driven down the price of natural gas with the glut in supply. In turn, this has helped the company to generate low-cost electricity from its gas-fired generators. An abundant supply of natural gas and the displacement of older or obsolete power technologies has positioned Calpine to deliver low-cost electricity well into the future. The company’s geothermal power plants position it well against environmental liabilities. (click to enlarge) Calpine’s status as a low-cost provider in the power generation space gives it a big competitive advantage versus competition. The company is well positioned for stricter federal and state environmental regulation, as it has substantially less greenhouse gas emissions than its peers. Competition is increasing in this commodity business As natural gas prices continue to make new lows on a weekly basis, Calpine benefits dramatically. It relies on natural gas to fire its plants. But what happens if there is a dramatic increase in prices for a sustained period of time? We wish we had the answer. Certainly, it represents a risk if natural gas continues increasing in price over the long term. Our view is oil & gas prices in the U.S are likely to be capped for the foreseeable future due to the glut of supply in the market. Alternative energy and solar companies are another threat. This threat is likely to be subdued in a low commodity environment, which makes many of the alternative energy sources more expensive. However, over the long term, renewable energy sources could dramatically hurt Calpine’s business if they gain traction and compete on a cost basis. Main competitors include Atlantic Power (NYSE: AT ), Talen Energy (NYSE: TLN ), Ormat (NYSE: ORA ), NRG Energy (NYSE: NRG ), and Duke Energy (NYSE: DUK ). Long wave of growth potential As we have mentioned before, Calpine’s gas-fired plants should benefit from the ample supply of natural gas in the U.S. over the long term. More importantly, the power industry is one of the largest industries in the U.S. We are all impacted by the generative capabilities of utilities. The deregulation of the power industry presented uncertainty in the markets for a period of time. Wholesale power producers increased competition dramatically and decreased Calpine’s geographic advantages. However, utilities bring with them incredibly high barriers to entry. The secular trends of abundant, affordable natural gas, increased environmental regulations, focus on grid reliability and pay-for-performance, and the need for capacity to help intermittent renewable should pave the way for outsized growth in the future. Management is shareholder-friendly and competent The company generates excess free cash in the amount of ~$700-800 million per year. This leaves plenty of excess capital for share buybacks and dividends in the future. Management has a strong track record of capital allocation that is accretive to shareholders. Since 2010, management has bought companies at an average of ~6x EBITDA, while it has sold companies ~14x EBITDA. It continues to monetize non-core assets through sales or contracts, and is firmly committed to returning capital to shareholders with the excess free cash that the company is generating. (click to enlarge) Bottom Line It’s our belief that this best-in-class operator is being unduly punished by the decline in oil & gas prices. The entire sector continues to get beaten up, while Calpine continues to generate excess free cash. The secular trends of abundant, affordable natural gas, increased environmental regulations, focus on grid reliability and pay-for-performance, and the need for capacity to help intermittent renewable should pave the way for outsized growth in the future. In addition, the company has $6.9 billion in NOLs that still need to be worked through. The market appears to be pricing Calpine for dead, as it trades at a substantial discount to its replacement cost. We find the shares to be incredibly attractive at current levels, with an FCF yield of 17.33% (low-end adj. FCF 2016) and EV/EBIT of 13.51. Future dividends and buybacks should prove to be additional catalysts for this heavily undervalued company. While we are not huge fans of the power generation business, Calpine should do very well for investors over time. Notable Shareholders: Bill Miller | Altalis Capital | Rivulet Capital | Addison Clark Please share your thoughts in the comments section below as I learn just as much from you as you do from me. It can be a timely endeavor, but I answer all of your comments and questions myself. Your patience and understanding is greatly appreciated. I will get to your comments as soon as possible. 🙂 (Source of the above figures: Company Presentation )